Cost-volume-profit (CVP) analysis focuses on the relationships of prices, costs, volume, and
mix of products. It is useful for determining the amount of units or total sales revenue the
company must earn at a particular level of profit desired. CVP analysis is based on the on the
profit equation:
Sales Revenue - Variable costs - Fixed costs = Profit
SPx – VCx – FC
= Profit
Where SP = sales price per unit VC = variable cost per unit
FC = total fixed costs
x =
number of units
In most situations, you will solve for x, the number
of units. Note the format of the equation includes the components of the variable costing income statement. Although some textbooks
provide specific formulas, the formulas are not very flexible.
The profit equation approach is
easier to remember
given that you already know the income statement format. The key is to remember that selling price and variable costs are in
units and fixed cost is a total. Total sales revenue is determined after you solve for the
number of units to be sold. If you buy 3 beers at
an
NFL football game for $8 each, sales revenue for the vendor at the stadium will be 3
times $8,
or $24.
Assumptions in CVP Analysis
When relying on analysis using CVP, we must remember four assumptions so we can
understand the limitations of the analysis: The assumptions are:
1.
Costs can be accurately separated into their variable and fixed components.
2. Both unit variable costs and total fixed costs remain constant within the relevant range.
3.
Inventory levels are zero or do not change.
4.
Costs are linear.
Using the profit equation, you can solve for both of the following at any level of activity:
1) units to be sold
2) sales revenue
12.
Cost Volume Profit Relationship
If all variable expenses are
deducted from sales revenue the resulting figure
is
contribution margin or contribution margin is equal to sales revenue minus variable expenses
(manufacturing and non-manufacturing). Click here to continue reading.
Contribution Margin Ratio (CM Ratio):
The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio). Click here to continue reading.
Contribution Margin Income Statement:
Contribution margin income statement is an income statement that is prepared to show the
contribution margin figure
in the income statement. A contribution margin income statement
is
prepared for the use of internal management. Click here to continue reading.
Break-even point is the level of sales at which profit is zero. At break even point total sales are equal to total cost (variable + fixed). Click here to continue reading.
Management desires to achieve a specific amount of profit at the
end of a business period.
The net operating income or profit that management desires to achieve at the
end of a business period
is
called target profit.
The excess of actual or budgeted sales over the
break even volume of sales is called
margin of safety. At break even point costs are
equal to sales revenue and profit is zero. Margin of
safety, therefore, tells us the amount of sales that can be
dropped be fore losses begin to be
incurred. Click here to continue reading.
Operating leverage is a measure of how sensitive net operating income is to percentage change in sales. Operating leverage is high near the
break even point and decreases with the
increase in sales and profit. Click here to continue reading.
Break
even Analysis with Multiple Products
- Sales Mix:
The term sale mix refers to the relative proportion in which a company's products are
sold.
The concept is to achieve the combination, that will yield the greatest amount of profits.
Most companies have many products, and often these products are
not equally profitable. Click here to continue reading.
CVP
Consideration in Choosing a Cost Structure:
The relative proportion of fixed and variable costs in an organization is referred to as cost structure. An organization often has some latitude in trading off between these two types of
costs. For example labor costs can be reduced by investments in automated equipments.
Click here to continue reading.
Importance of Cost Volume Profit (CVP) Analysis:
The most profitable combination of variable cost, fixed cost, selling price and sales volume
can
be found with the help of cost volume profit analysis. Click here to continue reading
Managerial accounting provides useful tools, such as cost-volume-profit relationships, to aid
decision-making. Cost-volume-profit
analysis helps you understand different ways to meet your company’s net income goals. This image describes the relationship
among sales, fixed
costs, variable costs, and net income:
The left axis indicates value in dollars.
Where total sales equals total costs, the company breaks even (which is why that’s
called the break-even point).
The shaded area to the upper right of this break-even point is profit.
The shaded region to the lower left is net loss.
Total
variable costs are a diagonal line because the higher
the production, the
greater
the
variable costs.
The total fixed costs
line is horizontal because regardless of the production level, fixed
costs stay the
same.
Total costs equal the
sum
of total variable costs and total fixed costs.
Limitations of Cost-Volume-Profit (CVP)Analysis:
Cost volume profit (CVP) is a short run ,marginal analysis: it assumes that unit variable costs and unit
revenues are constant, which is appropriate for small deviations from current production and sales, and
assumes a neat division between fixed costs and variable costs, though in the long run all costs are variable.
For longer-term analysis that considers the entire life-cycle of a product, one therefore often prefers
activity-based costing or throughput accounting.